RATIO ANALYSIS AS A BANK LENDING TOOL
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RATIO ANALYSIS AS A BANK LENDING TOOL
RATIO ANALYSIS AS A Bank LENDING TOOL, CHAPTER ONE
The goal of this project topic is to learn how bank lending is concerned with providing cash for needy customers as loans from the savings of fund surplus units paid into the bank in chapter one.
As a bank lending took is acceptable to both lender and borrower, this is the cornerstone of a bank with great care to be exercised in this activity in the ratio analysis.
In this chapter two, the notion of bank lending is an important function of commercial banking that involves the extending of loans to borrowers. Banks have some lending objectives, and having identified the problems and their impact on the appraisal of the borrower’s Financial position, bank policy will not be fully isolated from it.
The third chapter will discuss the research method and design using the experimental survey approach by interviewing authorities. These will be interpreted summarizingly.
In chapter four, data will be presented and analysed, and questionnaires will be used as research instruments.
Chapter five contains summaries of some of the research’s important findings as they relate to the main purpose, recommendations, and conclusion.
CHAPITRE ONE
1.0 INRODUCTION:
1.1 BACKGROUND OF THE STUDY:
Bank lending is concerned with the supply of cash for needy customers in the form of loans made from fund surplus units paid into the bank. Due to the established fact that the saved fund is at the bank’s disposal for a certain amount of time, the bank can thus provide these funds to their clients who may have a larger need for these funds at the moment.
By far one of the most services given by banks, the rationale for bank lending is the need to achieve some economic growth through lending to already existing firms for expansion and to persons with entrepreneurial aspirations to establish up enterprises and make profit. It is the foundation of a bank. This activity must so be approached with caution.
Some lending policies should be followed by banks, and some questions should be addressed regarding:
(a) To whom is the bank lending?
(b) How trustworthy is this customer?
(c) What is this customer’s reputation at this time?
(d) How much money may the bank lend to a single customer at one time?
Lending judgement is the true test of a bank’s skill, and as such, the bank should be concerned with the health of the business rather than just the consumer. Banks face significant losses as a result of loan nonpayment.
Before lending, banks should carefully construct an analysis and usage of financial statements. This study entails evaluating a company’s or borrower’s past, present,
and predicted future financial position to identify any weaknesses that could lead to future problems and to identify any strengths that the company/borrower could capitalise on.
Financial ratios are tools for financial statement analysis that can be used to answer certain critical questions about a company’s/customer’s well-being.
Important questions to consider include:
(a) How liquid is the business?
(b) Is management making enough money from the company’s assets?
(c) How does the management of the company finance its investments?
In two words, the answer to these problems is RATIO ANALYSIS.
According to UBAKA (1996), a ratio is a valuable tool for analysing a set of financial statements. It is the sole financial statement analysis tool available to accountants. The numerical relationship between two figures in a set of financial statements is defined as a ratio. It can be presented in a variety of ways.
The style of presentation used for any relationship under consideration is the one that the analyst can best interpret; for example, some people prefer to look at the periods, while others prefer percentage display.
The three basic financial statements that serve as the foundation for calculating financial ratios are as follows:
(a) A balance sheet is a statement of a company’s financial situation at a specific point in time, including assets, liabilities, and owner’s equity.
(b) The profit and loss statement (also known as the income statement) gives a measure of the net profit results of the firm’s operations over a specific time period. It is calculated on an accrual basis rather than a cash basis.
(c) Statement of charges in financial position (also known as the sources and uses of adds statement) gives an accounting for the sources provided over a specified time as well as the uses to which they are placed.
The above financial statements require little mathematics proficiency to analyse using financial ratios. Higher layers of management, who are in charge of maximising profits and planning for the future, benefit most from ratios.
To evaluate the data borne in financial analysis as to provide information about an organisation, one needs grasp the inner workings of financial ratios and the importance of various financial relationships. This information does not have to be confined to accounting data.
Past performance ratios can help anticipate an establishment’s future earnings capability and financial projections. We must be mindful of the various limitations of such data. Before granting a loan, we must look beyond the financial statement and consider the nature of the organisation,
its position within the economy, its activities, research expenditures, and, most importantly, the quality of its engagement (MATHER 1979). Financial ratios are classified into four sorts and are used to assess a company’s financial situation. They are as follows:
1. Liquidity Ratios: These ratios demonstrate a company’s ability to meet its short-term obligations. Liquidity ratios assess a company’s capacity to meet short-term obligations with its liquid assets.
These ratios are especially important to the firm’s short-term creditors since liquid assets comprise accounts receivable and other debts due to the firm that will create cash when those debts are paid in the near future.
Cash and other assets such as marketable securities and inventories are also included, both of which might be sold to generate funds to pay maturing short-term obligations.
The current and quick ratios are two types of liquidity ratios.
(a) Current Ratio: The current ratio is the most basic indication of a company’s capacity to raise funds to pay its short-term obligations. It is the current asset to current liability ratio. Current assets are considered relatively liquid, which implies they can create cash in a short amount of time.
If the current ratio is too low, the firm may struggle to meet short-term commitments as they mature. If it is excessively high, the company may be overinvesting in current assets.
To reduce a high current ratio, the component(s) of current assets that are too large should be reduced, and the funds should be invested in more productive long-term assets or paid out as dividends to the firm’s owners.
Current Asset = Current Ratio
Present Liability
(b) Quick or acid test ratio: This ratio assesses a company’s capacity to satisfy short-term obligations using its most liquid assets. Inventory is not included with other current assets in this situation because it is often significantly less liquid than other current assets excluding inventory dividend by current obligations. Thus:
Current Assets – Inventory or Stock = Quick Ratio
Present Liability
2. Leverage Ratios: Determine the level of a company’s entire debt burden. They demonstrate the company’s ability to meet its short and long-term debt obligations. These ratios are calculated by comparing fixed charges and earnings on the income statement or by comparing debt and equity components on the balance sheet.
These leverage ratios are crucial to creditors because they represent the firm’s ability to support interest and other fixed costs, as well as whether there are enough assets to pay off debt in the case of liquidation.
Shareholders are also concerned about these ratios, because interest payments are an expense for the company that grows with debt. If borrowing and interest rates are too high, the company may go bankrupt.
There are three types of leverage ratios:
Total debt divided by total assets equals the debt-to-total-assets ratio. Thus, the debt-to-total-asset ratio equals total debt (liabilities).
Overall Assets
Thus ratio is sometimes known simply as a debt ratio. In general, creditors prefer a low debt ratio since it indicates more protection of their position. A larger debt ratio often indicates that the firm must pay a higher interest rate on its borrowing, and that beyond a certain point, the firm will be unable to borrow at all.
Ratio of Interest Earned to Interest Paid
divided by the rate of interest
Thus, EBIT stands for Earnings Before Interest and Taxes.
(EBIT) As a result, EBIT
Charges for interest
This ratio represents the firm’s ability to pay annual debt interest from earnings. Creditors are sure that loan interest will be paid in this case since interest is well covered by Earnings Before Interest and Taxes (EBIT).
3. Fixed charges coverage ratio: This is calculated by dividing income available to satisfy fixed charges by fixed charges. All fixed naira outlays, including debt interest, sinking fund contributions, and lease payments, are included in fixed charges.
A fixed charge is a cash outflow that the company cannot avoid without breaching its contractual obligations. The company makes regular contributions into a sinking fund, which is eventually used to pay off the principal of the long-term debt for which the fund was established fixed costs coverage.
=Money available to meet fixed charges
Charges that are fixed
That is, operating income plus lease payments and additional income.
Interest + lease payment + before-tax contribution to sinking fund
The fixed charges coverage ratio displays how much money is available to cover all fixed charges.
4. Activity Ratios: Show how well a company utilises its total assets to generate sales. These ratios reflect if the firm’s current and long-term investments are too little or too large. If the investment in assets is excessive,
the funds tied up in that asset may need to be used for more immediate productive objectives. Furthermore, if the investment is insufficient, the company may provide bad customer service or produce its product inefficiently. We have the following under the umbrella of activity ratio:
(a) Inventory turnover equal to cost of goods sold divided by average inventory turnover implies a high level of stockouts. A low inventory turnover implies a significant investment in stocks in comparison to the amount required to service sales.
Excess inventory wastes valuable resources. On the other side, if inventory turnover is too high, inventories are too little, and the firm may be frequently running out of inventory (out of stock),
resulting in customer loss. The goal of this ratio is to maintain a level of inventory relative to sales that is not excessive while also being sufficient to meet customer needs.
(b) Average collection period: This is the time it takes from when the sale is made to when the cash is received from the consumer. This percentage represents the firm’s efficiency in collecting sales.
It could also indicate the company’s credit policy. The sooner the corporation receives revenue from sales, the sooner it may invest that money and earn interest.
(c) Fixed Assets Turnover: This measures how effectively the firm’s assets are leveraged to produce sales. This measures how intensely the firm’s fixed assets are utilised. A low ratio suggests excessive investment in plan and equipment relative to the value of output produced.
(d) Total Assets Turnover: This metric measures how effectively the firm’s assets are leveraged to produce sales. If it is low, it indicates that fixed assets are being overinvested in (James and Horne 1989).
(e) Profitability Ratios: These ratios assess the firm’s capacity to generate a net return on sales or investment. Because profit is a firm’s ultimate goal, bad performance shows a fundamental flaw that, if not remedied over an extended period of time, will almost certainly result in the firm going out of business.
Return on Equity (ROE): This is the best single measure of a company’s success in meeting its objectives. The goal of management is to maximise the return on shareholders’ investment in the company.
At the conclusion of this work, the challenges of bank lending would have been highlighted, as well as a method of obtaining effective and efficient bank lending through rigorous analysis and the use of financial statements in the appraisal of a borrower’s loan application prior to lending.
1.2 STATEMENT OF THE PROBLEM:
Because of the danger involved, banks are hesitant to make loans to customers. Bank lending, while necessary, is regarded as a risk due to the problems it is associated with. The problem of unpaid loans is a criticism of bank judgement; therefore, every bank must apply an examination of the borrower’s financial statement at a particular period.
The majority of banks are characterised by poor lending, which may result from a poor appraisal of the borrower’s financial statements. In most circumstances, banks share the customer’s common view that the fact that he is making a profit is an open scheme to the heart of the treasury,
and so the bank fails to recognise that there is no simple means of analysing the borrower’s financial status before lending. It is vital to ensure that funds for repayment are accessible at the proper moment when engaging in loan operations. The fundamental issue is thus banks’ incapacity to retrieve potential loans.
1.3 OBJECTIVES OF THE STUDY:
Ratio has been defined as a technique that may be used to facilitate the comparison of significant figures by expressing the relationship in the form of a percentage, allowing the borrower’s accounts to be interpreted by highlighting salient features thereof (Spice and Peglers’ 1971). This study focuses on analysing service functions supplied to lenders (financial institutions). As a result, the goals were as follows:
i. To learn how ratio analysis might help financial firms lend. In other words, to learn how commercial banks and institutionalised lenders use ratio analysis as a critical instrument for lending.
ii. To determine whether ratio analysis is genuinely useful to bank managers in determining a borrower’s financial performance.
iii. To investigate the importance of ratio analysis and how it might be used by bank management in lending decisions.
iv. To demonstrate how a diligent study, analysis, and use of financial ratios can assist a lender in gaining a good understanding of a borrower’s financial features and thus facilitate lending.
1.4 SIGNIFICANCE OF THE STUDY:
Having identified the difficulties to which the study logically links, the significance of the research is to bring these concerns to light and their impact on the lender’s estimate of the borrower’s financial status.
This study will look into the problem areas where managerial and other deficiencies have contributed to the ever increasing default in the steady loan repayment schedule by peasant borrowers as an institutional arrangement designed to promote economic and individual growth through loan advancement.
The research is critical since it is essentially an empirical investigation into the banks’ inadequate lending functions. When completed, the survey will reveal the methods used by banks and lenders to examine customers before issuing credit advances.
The study will also propose an active and efficient lending method based on financial statement analysis, interpretation, and use to enhance the loan process, which will be useful to banks and other institutional lenders. It is also significant since it will allow lenders (banks) to alter their lending evaluation, which will lead to poor lending.
Furthermore, the investigation will strive to uncover the heinous problems linked with peasant defaults on loan repayments made to clients. It will also investigate its impact on Nigeria’s economic environment.
The author contends that if the candid recommendations from the complete investigation are religiously followed, it will assist to restore normalcy and rationality in the method in which the borrower’s financial status should be reviewed by the financial lender before issuing credit extensions.
1.5 SCOPE AND LIMITATIONS OF THE STUDY:
The research is intended to include the financial ratios that financial lenders and other institutionalised lenders will use to analyse the borrower’s financial situation before issuing credit advances. It is general knowledge that sound lending by lenders is based on information provided to the lender about the borrower’s financial situation and performance prior to issuing credit advances as discussed.
The research is also intended to cover all of the fundamental principles underlying sound lending. This research work does not ignore the constraints of bank lending that lead to default in repayment of advances extended.
Again, the researcher went above and above to determine the aims of this Ratio Analysis (if any) and the roles it plays in decision-making regarding loans extended by lenders in order to achieve good lending.
LIMITATIONS OF THE STUDY:
The research is intended to cover a specific sample. Again, for easier data collection, the Union Bank of Nigeria Plc, Ogui Road Branch, Enugu was picked out of all commercial banks in the country.
Due to the country’s economic situation, the researcher had numerous obstacles in gathering data, such as high travelling costs. This was due to a significant increase in the general price of commodities, especially acute gasoline scarcity, which impeded my movement.
As a result, due to the nature of banking, which requires secrecy, it was difficult to elicit a variety of information from the bank’s workers. However, the research was limited to a single financial institution: UNION BANK OF NIGERIA PLC, ENUGU.
Starting from the obvious problems encountered by the researcher that affected the wider average for data collection, there were incessant lock-outs and certain industrial disharmony among the agitating workers of various departments of the institution at that particular period, the researcher chose to further limit the study to a specific branch of the institution located at Ogui Road, Enugu.
The dreadful scenario led to nonchallenge and the mistaken belief that answering questions and conducting interviews with outsiders would result in punishment from superior authority. Despite this, the researcher had to forsake some essential personal necessities in order to carry out the aim of this research endeavour.
1.6 THE STUDY’S HYPOTHESIS:
The researcher believes that developing a hypothesis is essential in order to have a solid foundation for this research effort. This hypothesis will act as the project’s guideline. The researcher is investigating whether Ratio Analysis as a bank lending technique has aided in the extension of credit to clients in the indicated organisation in any manner.
The following hypothesis will lead the research based on this.
1. The Null Hypothesis (Ho): Ratio Analysis has no use in bank lending.
2. The Alternative Hypothesis (H1): Ratio Analysis is used as a lending tool by banks.
3. That default in loan repayment is the result of an incorrect review of the borrower’s financial statements prior to issuing credit.
1.7 A SHORT HISTORY OF THE UNION BANK OF NIGERIA PLC:
What is today known as Union Bank of Nigeria Plc first arrived in Nigeria in 1917 as Barclays Bank Company (Dominion, Colonial, and Overseas), then changing its name to Barclays Bank International United, and finally to Barclays Bank Plc.
It had been a subsidiary of that bank until the Banking Decree of 1969, when it became a locally incorporated company under the name Barclays Bank of Nigeria Ltd, with its headquarters at 40 Marina, Lagos.
On March 12, 1979, the Board of Directors (BOD) changed the name to Union Bank of Nigeria Ltd, and then to Union Bank of Nigeria Plc. This was due to the shareholding structure moving to 80% Nigeria ownership and 20% Barclays Bank Plc, essentially making it the first Nigerian bank to have 80% Nigerian ownership.
However, Barclays Bank Plc recently ceded its 20% stake, giving it 11,000 employees and over 250 outlets across the country. It is also present in London and New York.
All other interactions with the outside world are handled through an agency agreement with the parent bank, Barclays Bank Plc. Over time, Union Bank Nig. Plc has positioned itself as a banking industry leader.
The achievement of net profit over the last five years speaks for itself. This has been made possible by the selfless service of its personnel, who have worked tirelessly to bring the bank to its current state.
Indeed, it employs the greatest number of people in the banking industry. Its slogan is “Big, Strong, and Reliable” in all senses, including capital and reserve basis.
1.8 DEFINITION OF TERMS:
(a) LENDING: The act of lending money to another for a set length of time with the expectation that it will be returned.
(a) BANK LENDING: This is concerned with the supply of funds for needy customers in the form of loans from savings units put into the bank.
(c) RATIO: Is a strategy used to facilitate the comparison of significant statistics by presenting the relationship in the form of a percentage, allowing the borrower’s accounts to be interpreted.
(d) FINANCIAL STATEMENT: This consists of a balance sheet, a profit and loss statement, and a statement of sources and applications of money. It provides information about managerial success or failure.
(e) P.M.O.S. stands for Profit Margin On Sales.
(f) R.O.T.A. stands for Return On Total Assets.
R.O.E. stands for Return On Equity.
(h) LOAN PORTFOLIO: A loan portfolio is the quantity of money that a borrower requires at a given time and the reason for requiring such an account.
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